Modern Economic Theory and Development

1. Modern Economic Theory and Development Karla Hoff Joseph E. Stiglitz October 8, 1999

2. Facts To Be Explained • Lack of convergence • Private capital flows to rich countries dwarf those to poor countries • Persistence of transitory shocks • Limited successes from market liberalization

3. Question: How Should We Conceptualize the Environment Facing an Economic Actor? Three Perspectives I. Neoclassical perspective • A price for every action • Generally, a unique equilibrium price vector • Focus on differences in endowments across countries • Key to success in elimination of government-created distortions

4. II. Information- Theoretic Perspective with a Given Set of Missing Markets • Information Externalities • Focus on taxes and subsidies

5. III. Ecological/Evolutionary Perspective • Pervasive externalities • Multiple Equilibria: [The plants and animals of the Galapagos differ radically among islands that have] the same geological nature, the same height. Climate, etc. . . .This long appeared to me a great difficulty, but it arises in chief part from the deeply seated error of considering the physical conditions of a country as the most important for its inhabitants; whereas it cannot, I think, be disputed that the nature of the other inhabitants, with which each has to compete, is at least as important, and generally a far more important element of success.

6. Path Dependence • Hysteresis (Examples) • Black Plague • Privatizing before regulating can doom competition • An episode of high levels of corruption can forever change incentives for honesty • Limited progress modeling evolutionary process • Great progress in understanding coordination failures (poverty traps)

7. Coordination Failures in Market Equilibrium Models I. Multiple Equilibrium in Factor Levels • Identical Agents; Continuous choice variable a • a represents R&D or investment • Each agent chooses a є [0,1] • U=U(a1; a, p) • Reaction function U1 = 0 implicitly defines a1 as a function of a

8. aI 1 Agent I’s Reaction Curve 45o a II III I

9. II. Multiple Equilibrium in Social Institutions • Identical Agents • Each agent has choice between two activities • x = fraction of agents who undertake first activity U= U(a; x, p) where a є {1,2} • Equilibrium: x* equal to 1/ between 0 and 1/ more than 1 as U (1; x*, p(x*)) > U(2; x*, P(x*))

10. Examples Sah and Stiglitz (1989) • Each agent chooses “bureaucratic” v. “Innovative” behavior. • x = fraction of “innovators” in the populations or Greif (1994) • Each agent chooses “collectivist” v. “individualist” enforcement • x = fraction of “collectivist” enforcement

11. Examples (continued) de Meza and Gould • Government defines (but does not enforce) property rights • Identical landowners and identical workers • Each landowner chooses whether or not to pay a fixed cost (e.g. fence, patrol, etc) to enforce his rights • Each agent can then hire labor and earn rents F(L)-w(L) L= labor hired by each landowner x=fraction of landowners that enforce w=w(x)

12. F(L) - wL Cost of Enforcement 0 1

13. W* Choose Activity 1 Choose Activity 2 III. Multiple Equilibria in Organization • Individuals differ by wealth W • F(W) is wealth distribution • Equilibrium U(1, F(W*), W*) = U (2, F(W*), W*)

14. Example Hoff and Sen: A Parable of Capitalism • Each firm has one manager • Manager chooses whether or not to put in high effort • His efforts benefit not only his firm, but also create spillover effects on other firms in the local economy • spillovers in marketing • spillovers in learning • tax payments that finance local public goods

15. Hoff and Sen (continued) • A manager will have an incentive to expand effort only if he has a sufficiently high equity stake in the firm • Interest rate for borrowing exceeds interest rate for saving • W* is cutoff level of wealth such that richer managers buy equity and put in high effort, and poorer ones do not. Results: • Multiple Equilibria in W* • Changes in F(W) can destroy an equilibrium • With local interactions and mobility across industrial belts, “pockets of poverty” can emerge

17. So What? Is the Ecological/Evolutionary Perspective Useful? 1) It explains the 4 puzzles. 2) It changes our perspective on market failures Neoclassical Perspective Eco/Evo Perspective Public Goods Lighthouse Contract Enforcement Institutions Externalities Bees Search Costs in Labor Market Path Dependence QWERTY Incentives for Honesty if Reputation is “Collective”

18. 3) It changes our perspective on forms of government intervention • Information as an Intervention • Deep versus Shallow Interventions • Reform Sequencing • Fixed Costs of coalition formation =>hysteresis • Temporary taxes/subsidies can have permanent effects

19. 4) It shifts the boundary between exogenous and endogenous variables • A: Urban-rural wage gap • If urban wage is rigid and there is no migration, Srinivasan-Bhagwati sows wage subsidies can lead economy to first-best • Suppose Harris-Todaro migration and urban-rural wage gap is endogenous arising from urban sector”efficiency wage” (Stiglitz 1974 turnover model), then there is NO scope for rigidities

20. B: Rural-credit markets • Suppose rural moneylenders have market power. If their costs are exogenous, then government subsidies will “trickle” down to poor. • But, if their enforcement costs are endogenous, and there is Greifian collectivist enforcement, then subsidies =>new entry=>weaker enforcement =>i can arise (Hoff-Stiglitz) • Implications for transition economies when “everything” is endogenous

21. 5) It changes our perspective on political economy • Pareto Improvements need not be implementable • An increase in the number of winner from a reform may make it less implementable • An encompassing interest by one party may be deleterious to outcomes • Resolution of paradoxes? Reforms have effects on: • bargaining power • credibility of commitments • information flows